Capital Thoughts as Q1 Winds Down

The first quarter is winding down. For most investors it has been a good quarter. The performance of the US stock indices have risen more than they did all last year. Major bourses in Continental European bourses, like Germany, France, and Italy rose 10% thus far. The UK’s FTSE posted a respectable 7% gain. Japan’s Nikkei was rallied nearly 40% in the second half of last year managed to tack on almost another 3%.

Global bonds, on the other hand, fell amid US and ECB rate hikes and signals from the BOJ that the days of extraordinary monetary accommodation are nearing an end. In addition, data suggests that after a disappointing Q4 05, growth in the US and Europe recovered in Q1 06 and the most indications suggest the Japan’s economic recovery continue to broaden and deepen.

The major currencies have been large range bound throughout the first quarter. The euro has largely been confined to a 2 cents range on either side of the $1.20 level. In statistical terms, based on historical volatility over the past 150 days, the band is equivalent to about one standard deviation around the $1.20 level.

Against the yen, the dollar is virtually unchanged over the past three months. After a short covering rally help bolstered the yen in December 05 and January 06, the dollar spent most of the Feb-Mar period in a four yen range centered near JPY117.50, which incidentally also corresponds to the 100 day moving average.

Judging from anecdotal data, the general pattern of prices and some proprietary data, is appears that many institutional investors front-loaded their emerging market allocations at the start of the year. However, after early February, with fear of higher G7 interest rates and valuation concerns, many institutional investors appeared to sit tight or on the margins book profits.

After we get past the Japanese fiscal year end, the quarter end and the FOMC statement on March 28, new capital allocation decisions will be made and new funds may be committed. With additional rate hikes by the Federal Reserve and the European Central Bank expected, global investors may show a preference for equities over fixed income.

In addition to the front-loading of flows into emerging markets to the extent that Q1 06 inflows appear, by some industry estimates to come close to the entire amount committed to emerging markets in 2005, the other noteworthy development has been the surge in M&A activity. This is true in the US, but is exceptionally true Europe. According to Standard & Poor’s, merger and acquisitions reached a fevered pace in the Jan-Feb period, and with deals announced worth in excess of 230 bln euros, the pace is on the magnitude of four times the same 2005 period. Moreover, S&P reports that three-quarters of the transactions are financed by cash or bank loans. This is bullish for share prices on two counts. First, those whose shares are bought have new cash to invest and there are few issues. Second, the fact that companies are paying for acquisition in cash rather giving shares offers a prima facia case that executive view their shares as under-valued.

Another major development has been the assumption of Benjamin Bernanke to the helm of the Federal Reserve. Bernanke has promised to continue to work that had begun under Greenspan to make the Fed even more transparent. As an aside, a folk story on Wall Street has it that Greenspan had a sign in his office that said “If you think you understand what I said, you have misunderstood.”

In the early days of this tenure, Bernanke appears to have jettisoned his predecessor’s affinity for strategic ambiguity. He has been unusually clear: price stability is the key to sustained growth, the Fed cannot target asset prices, and in any event the housing market does not pose a significant risk to the US economy. Neither do the low long-term bond yields or the yield curve inversion portend a worrisome economic slowdown. Lastly, Bernanke has also made it clear that while the current account deficit poses some risks, its correction is can take place smoothly with precipitating a crisis or a destabilizing dollar decline.

Yet despite the clearer signals from the Federal Reserve, the market’s expectations of Fed policy have been particularly volatile and the swings in expectations have largely coincided with swings in the dollar in general. At the start of the year, the market has had fully discounted one rate hike and was leaning toward another one by mid-year, but did not have the second hike completely discounted. The euro had rallied from its low for the year near $1.1640 in the middle of December through late January when the euro’s Q1 high was recorded near $1.2325.

Starting in late January as it became clear that a combination of factors, including unseasonably warm weather throughout much of the US, was going to fuel stellar Q1 growth and as many economists revised up their forecasts for Q1 GDP, the market began pricing in additional Fed tightening. The yield implied by the July Fed funds futures rose by more than 40 bp between late January and mid-March. During that time, the euro dropped about 5 cents.

Yet in its adjustment, the market appeared to exaggerate by beginning to price in 3 more quarter point hikes the first half (March, May and June). Even for us, who are among the most aggressive forecasts of Fed policy, thought this was too much. As this exaggeration was corrected, the euro rallied to hit a high near $1.22 on St. Patrick’s Day. Then with the help of an uncommonly unambiguous speech by Bernanke on March 20, the market sold the Fed funds futures and sold the euro.

But the market remains fickle and an unexpectedly sharp decline in new home sales saw players once again reconsider the likely trajectory of Fed policy. And once again the market is not fully confident that the Fed funds target will be lifted to 5% by mid-year. Like night follows day, the dollar was sold off.

Simply statistical analysis bears out this narrative. Through the first quarter, the euro-dollar exchange rate enjoyed a higher correlation with the July Fed funds futures contract (0.54 with 1.0 being a perfect correlation) than with bonds, notes or the equity market. This offered a better guide to the dollar’s movement than the size of the trade deficit, what some Middle East countries may or may not do with their reserves, or even the fashionable TIC data.

In contrast, the correlation between the euro-dollar exchange rate and the expectations for ECB policy, as reflected in the Euribor futures is about 0.12. That means that statistically speaking changing expectations for ECB policy did not offer much help in trading the euro. Although the past is not always a helpful guide of the future, the risk is that in the coming months, the most actively traded currency pair in the $2 trillion a day market, remains hostage to the Federal Reserve.